Melancholy of Realty

Photo by Chris DeversThe destiny of realty is dependent on the economy’s progress. But setting price targets is an empty exercise. Derivatives did infuriated problems but the issues started with lending aberration.Rating agencies gave bad loans higher ratings than deserved and due diligence was pathetic. Some Related Stories News Now – Tall is beautiful for realty players in Mumbai – MARKET VOICE: Senior VP, Jaypee Capital – Textile mills,Saurav Arora, ride realty boom to sell land, raise cash – Real estate projects upgrading in Tier-II and Tier-III cities. Most derivatives were extensions of securitisation, which is a well-established system. A loan can be reduced to a net present value at a negotiable discount rate. For instance, a one-year loan of Rs 100 is made at an interest rate of 10 per cent, when the fixed deposit rate is 9 per cent. The NPV of that future Rs 110 is Rs 100.92 at a discount rate of 9 per cent.The risk involved is directly proportional to discount rate. Note that since the future cash flow is zero the NPV of a bad loan is zero . Bonds may be issued against aggregate cash flow. If the parceled loans have different ratings and rates, the holders of more secure loans (senior tranches) receive less interest while the holders of high-risk tranches receive more interest. If contributors to such securities want protection, they can take out credit default swaps. The US real estate industry built impressive pseudo programs upon these concepts. Collateralised debt obligations (CDO), as the securities issued on bad contracts were called, were covered by CDS. If there had been honest ratings on loans, the CDOs would have been priced close to zero. But CDOs weren’t traded on exchanges. As a result, there was no price-discovery. Abdicating all derivatives as a consequence of elementary intermission in due diligence is not so intelligent. If CDOs had been standardised into lots and exchange-traded, the problems would have been a bit light far before. Information would have been immensely available and exchanges would collect quite appreciable margins from traders. So prices would have crashed but defaults would have survived. Off-exchange derivatives are often non-standard because they are adjusted for particular requirements. Suppose typical currency and interest rate swaps. An importer needs some predetermined amount of a given currency this month and decides to return that amount next month. Or, somebody wants to convert a fixed interest rate to a floating rate. A negotiable swap is a more sensible decision. So regulators will have to opt some ways to allow normal business transactions while preventing absurdity. India lacks a secondary debt market and lack of timely legal recourse in case of default. This makes lenders extra alert. This is not cause for self-praise. Financing would be easier if liquid debt markets existed and lenders were more assured of debt-recovery. This will lead to a faster growth.Indian realty developers are permanently cash-smacked. For a short while, they found it comparatively easier to raise money before the US crash. In the past one year, housing finance loan volumes have shown some signs of recovery but this is confined more in tier 2 and tier 3 cities and in “affordable housing”. The global gradual halt also meant project slowdowns so there won’t be enough action presently. Credits are only booked when a project is completed and sold. As a result, many developers will gain significant credits in 2011-12. Most developers have projects ready but those will be delivered in 2011 and 2012. Using assumed prevailing prices at the time of delivery, the NAV per share of a real estate developer can be calculated. Share valuation methods all depend upon imaginations. But this system has so many complicated valuation aspects that it’s probably best ignored. If the economy hikes, real estate will make a recovery. But, setting price targets is an exercise in vain.